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Want to get defensive? Stay away from this value trap

Want to get defensive? Stay away from this value trap

The market’s volatility over the last week and a half has started to put a lot of people on edge. I’ve noticed an increasing number of talking heads on market media starting to throw out words that just don’t apply to the market yet, like “correction” and even “bear market” in a few cases. It’s pretty easy to get caught up in the hand-wringing and anxious nerves that always seem come when market volatility starts to pick up. It’s a little harder to try to keep a clear head and filter through the mountains of information that is out there to make sense of things.

One of the clear symptoms of increasing market volatility and investor anxiety is increasing activity in bonds – especially in Treasury bonds, where investors will often seek safe haven from the stock market’s volatility and uncertainty. This is often called a “flight to quality,” as investors shed riskier assets and actively accept the much lower returns offered by bonds in exchange for the relative comfort of knowing they won’t lose money. Another reflection of the flight to quality attitude comes in the tendency of a lot of investors to shift their stock investments into industries that are expected to be less sensitive to the economy’s cyclical nature and should remain relatively stable even if it, and the market does in fact turn lower.

As a value-oriented investor, I prefer to keep my money working for me as much as I can. I’m also not a fan of dumping stocks in favor of bonds, simply because Treasury bonds have a relatively poor history of keeping up with inflation. I think that the tradeoff most people don’t think about as they shift out of the stock market and into “safe” assets is the deterioration of purchasing power that almost always comes with them. At best, they may track inflation roughly in parallel; but the truth is that if your investing goal should be to increase your purchasing power over time, you need to work with instruments that offer larger returns over time.



That’s why I prefer to keep working with the stock market, even when it is turning lower and starting to shift to bear market conditions. It is important when that happens to shift your investing rules to be more conservative, both in how frequently you take on new positions as well as how much of your money you allocate into those positions; but if you want to give yourself the best opportunity to see your money grow over time, the stock market has proven itself time and again for decades as the most productive way to do it.

So what are the “defensive” industries that could offer investors a way to keep using the stock market without the kind of major risk exposure that more cyclical sectors or industries carry? One example is the Food industry; the truth is that you’re not going to stop going to grocery store, and even if the economy does turn negative and force you to start tightening your finances, your food budget is likely to be one of the last things you’ll be willing to sacrifice. That means that there are a lot of good companies in that industry that I think can provide some good investing opportunities. These are stocks that may still go down if the market shifts into a bearish trend; but their declines are likely to be less severe than other areas of the market, and if you can find a fundamentally strong stock that is already significantly undervalued, the chances that it could actually keep its head above water, even in a bear market are actually increased. That’s one of the reasons that lately I’ve been writing a lot more about some of the different stocks in this industry that I think could be attractive.

The thing you have to be careful about, though is the value trap. Value traps are stocks that are significantly undervalued, based on the same kind of valuation measurements like Price/Book and Price/Cash Flow ratios that I rely on heavily; in fact, they could offer outsized returns that may seem just too good to pass up. When you dig into the fundamentals of those stocks, however you find other elements that should make you wonder if the stock is undervalued because it should be. Dean Foods Company (DF) is exactly the kind of stock that I think represents a significant risk to the average investor. It is currently trading near its lowest levels in twenty years, well below $10 per share. Some folks like to pay attention to low-priced stocks just because they’re cheap, but you have to be careful to figure out why they’re cheap. If the fundamentals are weak, you could be looking at a stock that could still get much worse before things get better – if they ever do.



Fundamental and Value Profile

Dean Foods Company is a food and beverage company. The Company processes and distributes fluid milk, and other dairy and dairy case products in the United States. It is engaged in manufacturing, marketing, selling and distributing a range of branded and private label dairy and dairy case products. It offers branded and private label dairy case products, including fluid milk, ice cream, cultured dairy products, creamers, ice cream mix and other dairy products to retailers, distributors, foodservice outlets, educational institutions and governmental entities across the United States. It also offers juices, teas and bottled water. As of December 31, 2016, the Company had over 50 national, regional and local dairy brands, as well as private labels. As of December 31, 2016, the Company’s national, local and regional licensed brands included Alta Dena, Hygeia, PET, Arctic Splash, Jilbert, Pog, Barbers Dairy, Purity, Berkeley Farms, Land-O-Sun & design and ReadyLeaf, Broughton. DF’s current market cap is $685.3 million.

  • Earnings and Sales Growth: Over the last twelve months, earnings declined almost -24%, while sales grew a little over 1%. In the last quarter, earnings increased 14% while sale declined about 1.5%. The company also operates with a deteriorating margin profile, since Net Income versus Revenues deteriorated from a paltry .17% over the last twelve months to -2.05% in the last quarter.
  • Free Cash Flow: DF’s free cash flow is relatively healthy and translates to a Free Cash Flow Yield of about 13.3%. This is a counter to the negative earnings and profitability picture I just painted, but is one of the only bright spots in DF’s fundamental profile.
  • Debt to Equity: DF has a debt/equity ratio of 1.39. This is a high number and is confirmed by the fact the company’s balance sheets shows more than $855 million in long-term debt against only about $25 million in cash and liquid assets. The company’s ability to service its debt is seriously in question.
  • Dividend: DF pays an annual dividend of $.36 per share, which translates to a yield of 4.8% at the stock’s current price. That’s a very fat dividend, which may be tempting, but be careful; the company’s negative earnings profile means they are paying out more in dividends than they are actually making. Given their nonexistent margins, high debt, and weak cash position, the sustainability of their dividend is increasingly doubtful.
  • Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for DF is $6.76 per share and translates to a Price/Book ratio of 1.1 at the stock’s current price. Their historical Price/Book average is 2.6, which suggests that the stock is trading at a major discount now of about 134%. That’s the trap; if you work strictly off of the valuation measurement, you might be tempted to believe the stock’s long-term target in the $17.50 to $18 range doesn’t seem all that far-fetched; but given the fundamental weaknesses I just outlined, where do you think the catalyst to drive the price to that level is going to come from? The fundamental picture needs to turn much more favorable before I would be willing to work with this stock in any kind of context.



Technical Profile

Here’s a look at the stock’s latest technical chart.

 

  • Current Price Action/Trends and Pivots: The chart above outlines the stock’s movement over the past year. It’s pretty easy to see the stock’s decline over the past year from a late-2017 high at a little below $12 per share. The stock does appear to be forming a support base a little above $7 per share right now, but keep in mind that if it does manage to stage a rally, it has strong resistance at around $8.25 per share, with additional resistance at around $9 per share. The strong of the downward trend, combined with the company’s fundamentals, really do imply the stock is unlikely to find any significant bullish catalysts in the near term. If the fundamental picture remains negative, it isn’t out of the question to say the stock could drop below $7 and test its all-time lows below $3 per share.
  • Near-term Keys: Any kind of bullish trade you might think about right now is extremely speculative in this stock, no matter whether you want to take a long-term position or try to work with a swing or momentum-based short-term approach with call options. Given the stock’s current support base, a bearish trade with put options or shorting the stock isn’t a high-probability set up either; however a push below $7 could offer a decent signal to think about if you want to try to bet on the stock dropping even closer to $0 than it already is.


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